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As we now know, banks were the incubator for the economic collapse. By looking at a measure called beta, investors could have detected increasing risk in bank stocks well before financial Armageddon.

Bank of America ( BAC), Citigroup ( C) and Wells Fargo ( WFC) shareholders suffered through a tumultuous year. It didn't have to be that way. Risk-averse investors could have sold off their holdings before most of the losses by paying attention to the beta value of the companies' stocks.

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Beta is a measure of the systematic risk in a holding, meaning it measures the sensitivity of a stock to the market as a whole. A beta of 1 suggests that a stock and the market should move in sync. A beta of 2 means the stock will gain twice that of the market and, on the flip side, lose twice as much.

Some people confuse beta with correlation. While those measures are similar, correlation takes into account only the direction of a price change. As a result, correlation can range from plus 1 to minus 1. A correlation of 1 simply means that when the market goes up, the holding will also go up, but not necessarily by the same amount.

Beta factors in the magnitude of the change as well. Because of this added benefit, beta can be used to determine increasing or decreasing volatility vs. the market as a whole, if the observed beta is climbing. As the holding is becoming more sensitive to systematic risks, it's therefore a more risky investment.

Values near 1 can be considered to have average risk. As beta falls to zero, the volatility of the stock decreases and it can be considered less risky. Stocks with betas of 1.5 and higher have a significant amount of systematic risk that investors should seriously consider before making an investment.

The calculation of beta requires the use of a computer. A typical beta calculation will use weekly returns over a two-year period. The formula can be written as follows:

Beta = Covariance of the stock returns to the market returns/Variance of the market returns.

TheStreet.com's quote page contains the beta value under the "Ratio Comparison" tab, making it unnecessary to compute. Click here for an example using General Electric ( GE).

The following table shows beta values for the past four years, calculated using weekly returns from January to December, for Bank of America, Citigroup and Wells Fargo.

Looking at this table, it becomes clear that risks rose considerably even before the credit crisis began to unfold:
BAC C WFC
Current Beta 2.8 3.4 2.1
2009 4.6 4.5 3.7
2008 2.1 3.1 1.6
2007 1 1.6 1.1
2006 0.8 0.8 0.6
Note: These numbers may differ slightly from those on TheStreet.com due to some calculation differences.

In 2007, Citigroup's beta doubled, showing greatly increased market risk. Wells Fargo's almost doubled, and Bank of America's climbed by 25%.

These trends increased in 2008, with Bank of America more than doubling and Citigroup almost doubling. From there, the numbers continued to climb to their current elevated levels.

The use of beta is a reliable way to determine systematic risks. While there remains a portion of unsystematic risk not captured by beta, it's still a good measure to gauge the risk in a stock.

Bank stocks still have very high betas. While the companies may be doing much better than they were at the end of 2008, there is still a good deal of risk that investors should consider carefully. As the beta drops and the risk falls in line with that of the market, banks will again be considered a safe play.

TSC Ratings provides exclusive stock, ETF and mutual fund ratings and commentary based on award-winning, proprietary tools. Its "safety first" approach to investing aims to reduce risk while seeking solid outperformance on a total return basis.
Prior to joining TheStreet.com Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level II CFA candidate.

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